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How to Analyze a Distressed Company (an Introduction) – Salon Media Group

The Salon Media GroupIn my last article, I described some of the ways in which individuals can invest in the distressed space. I also described why I think that for the average person it’s generally a much better idea to not try to make individual investments, but rather put money into a fund that has a good track record, or in an index.

These funds are run by professionals who have more experience and greater resources at their disposal than the individual investor. And even with that advantage, some 75% of them don’t beat the market average in any given year. So, an individual making his or her own picks in the market is at a serious disadvantage.

That said, I think everyone who is considering investing through a fund should still have a good understanding of how they go about deciding where to put money—and, of course, this knowledge is absolutely critical for anyone determined to make their own selections in the distressed market. By understanding the various characteristics that can make up a distressed company, you’ll be able to see beyond the self-evident views that everyone else makes (like, “that company stinks, I’m going to stay away from a position in it”). After developing this knowledge of distressed investing analysis, you may be able to look at that same business and determine rather that, “although this business stinks, everyone thinks it stinks, and everyone is selling off now, making it too cheap,” or, “everyone else thinks this company stinks, but I think it stinks less than they do,” or even “everyone else thinks this company stinks, and it’s true that it is not bringing in much revenue now… but it does own a bunch of real estate, and the stock is trading at a huge discount to the value of that real estate.”

Salon Media Group presents an interesting case study. Founded in 1995, it manages the website Salon.com, an internet news site. The news business has been hit hard in recent years, with giants like the Boston Globe, once having had global aspirations, scaling back to being primarily a local focused newspaper. Decreases in advertising revenue have led to layoffs throughout the industry for years as internet-based alternatives have stolen their thunder and caused companies to scale back.

Salon stock chart

Salon stock chart

Salon’s stock trades fairly thinly, but they are now offering a sizable amount (some $3,000,000) in an offering to the general public for 25 cents a share. Salon is a fairly widely known name, and while not a distressed investment, they are certainly stressed. They offer a compelling view in their investor relations presentation. As you can see from the above image however, to say there is significant volatility in the stock would be an understatement. Having fallen from the low 2 dollar range pre-2008, they have traded in the last year for as high as 39 cents and as low as 13 cents. When looking at such a wide trading range, the first question to ask one’s self is whether the company’s true inherent value is now a mere 1/3 of what it was just 3 months prior. Oftentimes, the answer will be no.

I’ve inserted black bars in the above picture to emphasize the stock’s volatility – stocks tend to be more volatile the further you get from an earnings release, and the bars highlight this. Everyone had access to the same information, but between November of last year and this past February the company traded for as much as 30 cents and as low as 13. So you can get in to many stocks like this, either buying the stock directly, or “shorting” the stock[1] with a significant upside potential. If you had decided after their last earnings release that the company was worth 15 cents, for example, you could have realized a 50% gain within the span of less than 3 months. You could then take that money out of the market for the rest of the year and you would have better returns than the S+P had over the last year (some 13%). This is the moodiness of what Ben Graham described as “Mister Market,” in action.

Salon Annuals

Salon Annuals

Salon Most Recent Quarter

Salon Most Recent Quarter

Now look at these revenues. Interestingly, Salon has grown year over year, from 2012 to 2014. And yet the company still has posted significant, multi-million dollar net losses, while trading at a value that indicates it is worth some $13 million currently. This is at odds with their pitch, which describes them as a growth story. Notice that they describe themselves as having almost quadrupled their internet traffic between 2012 and 2014, while remaining unprofitable.

So, this gets to the heart of the issue. Currently running on thin ice, they describe themselves via their website as looking to raise $3 million to continue operations. They claim to have $1 million already committed, suggesting that other people have already looked the deal over and put up that much money

(http://www.deallabs.com/salon/deal), but if you take a closer look, their 10-Q filing reveals that all of that money came from company insiders, and thus it is not an indicator of general market enthusiasm.

During the current and previous fiscal years, we have relied on funding from related parties. Through February 13, 2015, our chairman has provided $5,676 ,000 in outstanding cash advances. We remain dependent upon our two largest stockholders for continued financial support while we seek external financing from potential investors in the form of additional indebtedness or through the sale of equity securities in a private placement. We are working with our advisors in our efforts to obtain such funding, and explore strategic alternatives. In September 2014, we began the solicitation of potential investors in accordance with Rule 506(c) of Regulation D under the Securities Act of 1033, as amended. However, we do not currently have any agreements in place to provide any financing, and there is no certainty that we will be able to enter into definitive agreements for additional financings or other strategic alternatives on commercially reasonable terms, if at all. [emphasis added]

This drives home the importance of the individual investor getting in at an appropriate level of the capital structure. What does that mean? It means that Salon has decided to try to raise funds by selling the inherently more risky stock in the company, which they have no immediate need to deliver returns on. Wisely for them, this raises cash but avoids the additional cost of new interest payments on debt. Individuals should always consider how risky they want their investments to be, and since equity holders are always the last group to be compensated in a liquidation (if at all), it is the riskiest option for investment. Investing in the debt of the company, which is more senior to the equity in a liquidation (and far more so if it is secured debt), provides access to a lower level of risk. Although one might look optimistically for a winning scenario for the company, like doubling its stock price, it is essential to still take note of the fact that the stock is being offered at an almost 100% premium to a recent trading price. Since debt is a safer bet, the riskier equity position should have some significant appreciation upside to make it attractive—otherwise, why take the risk?

So, when it comes to stocks, it may be true that you can’t always judge a book by its cover—but you can often judge it by its table of contents. We took a look under the hood at the pertinent features of Salon and found some areas of concern that the distressed investor should carefully consider.

Next in the series, I’ll go in to more specifics about how to estimate current and future value of a company. In the meantime, remember that investing in equities of a stressed or distressed company is an extremely risky proposition with a significant possibility of capital loss. There are alternatives to stock investments, including debt purchases, which may offer a better risk/reward tradeoff. And, if not already obvious, it is preferable to look at objective facts (such as a company’s actual SEC filings) than rely on their sales pitch, given the possibility that one may find a disconnect between the two.

Suggested reading for development:

An interesting and more exhaustive case study of another distressed company, as laid out by Houlihan Lokey, a well known bank in the distressed/restructuring space – http://www.hl.com/library/bsttcacs.pdf

[1] For those not familiar, “shorting” a stock is a common market trade in which the investor borrows the stock from a brokerage firm or bank and immediately sells it at what they believe to be a currently high market price, and then later returns the borrowed shares by buying them back at a lower market price. Thus, the investor profits off of the decrease in price.

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